Insurers face curbs on 'shadow banking' risk

Insurers are facing a crackdown on complex interactions with lenders to
prevent a dangerous new kind of "shadow banking" emerging that
could pose a risk to financial stability, the Bank of England's deputy
Governor has said.

Paul Tucker told the Association of British Insurers (ABI) that already unpopular regulations on "liquidity swaps", whereby banks pay insurers a fee to switch lower quality assets for high quality ones, do not go far enough.

"Internationally, the authorities are going to have to go further, putting some structure around these markets," Mr Tucker, the Bank's deputy Governor for financial stability, said.

As a "market-led solution", he proposed a "trade repository" – where all transactions are recorded – to resolve regulators' concerns about lack of transparency.

Regulators fear that the current all-consuming focus on banks could result in risk being passed on to insurers, putting them at the epicentre of the next financial crisis.

"Liquidity swaps" are considered potentially dangerous because insurers end up holding risky bank loans and because "the market is invisible", Mr Tucker said. "Securities lending allows anyone holding a portfolio of stocks and bonds to build themselves an in-house shadow bank," he added, drawing comparisons with the bailed-out US insurer AIG, which "blew up when its stock-lending shadow bank suffered a run".

"The importance of this will be underlined as we move towards a world without a safety net for banks, leaving holders of bank bonds exposed to risk," he told the ABI. "Insurers are significant investors in bank paper. In the future, whether in the UK or elsewhere, you will not be protected by an implicit guarantee from the state for those investments."

Despite the threat of tighter regulation in some areas, Mr Tucker joined the growing number of critics of Solvency II, the new European rules for insurers due to come into effect in 2014.

"At the Bank, we have been dismayed by how much it is costing the industry and the regulator to adapt. We are also concerned that it risks being too complicated," he said. "We need to be wary of regulators drowning in masses of data. Unless we are careful, it risks distracting supervisors from the big risks."